2.4 Demand-side and supply-side policies

Question 1

What are the two types of macroeconomic policy that a state can implement?

Answer 1

• Demand-side policies
• Supply-side policies

Question 2

Define: demand-side policies

Answer 2

Policies that focus on changing/shifting aggregate demand in an economy to achieve objectives.

Question 3

What is a discretionary policy?

Answer 3

A policy involving active and purposeful intervention from the government to influence aggregate demand.

The policy is at the discretion (choice or will) of the government.

Question 4

What are the types of discretionary demand-side policies?

Answer 4

• Fiscal policy
• Monetary policy

Question 5

What are non-discretionary policies?

Answer 5

Policies that rely on automatic stabilisers instead of direct government intervention.

Question 6

What are stabilisation policies?

How is this shown on the business cycle graph?

Answer 6

Fiscal or monetary policies that attempt to reduce short-run fluctuations of the business cycle, as they seek to ‘stabilise the economy’

The peaks and troughs are flattened.

Question 7

What is fiscal policy?

Answer 7

Policies that manipulate government expenditures and taxes to influence the level of aggregate demand.

Question 8

What are the sources of government revenue?

(3)

Answer 8

• Taxes of all types
• Sale of goods and services (e.g. public goods)
• Sale of government-owned property or enterprises

Question 9

What are the types of government expenditure?

What do they mean?

(3)

Answer 9

• Current expenditure: Government’s day-to-day spending (e.g. wages, NHS, schools etc.)
• Capital expenditure: The production of physical capital (e.g. roads, ports, HS2 etc.)
• Transfer payments: Taxes to welfare

Question 10

Define: Government budget

Answer 10

A type of plan of a country’s tax revenues and expenditures over a period of time (usually a year).

Question 11

What is:

1. A balanced budget
2. A budget deficit
3. A budget surplus

Answer 11

1. If taxes are equal to expenditures over the budget period
2. If expenditures are greater than taxes over the budget period
3. If taxes are greater than expenditures over the budget period

Question 12

What components of aggregate demand can fiscal policy affect?

Answer 12

• Level of the government spending (G)
• Level of consumer spending (C)
• Level of investment (I)

Question 13

What is expansionary fiscal policy?

Answer 13

Fiscal policy that seeks to increase output (usually to close a recessionary gap and to achieve slow and stable growth)

Question 14

What might an expansionary fiscal policy consist of?

Answer 14

• Increasing government spending
• Decreasing personal income tax
• Decreasing corporation tax
• A combination of increasing spending, and decreasing tax

Question 15

What is contractionary fiscal policy?

Answer 15

A policy that attempts to decrease (or the rate of) growth (usually to close an inflationary gap).

Shifts AD left

Question 16

What might a contractionary fiscal policy look like?

Answer 16

• Decreasing government spending
• Increasing personal income taxes
• Increasing corporate taxes
• A combination of decreasing spending and increasing taxes (austerity)

Question 17

What is the ratchet effect in the Keynesian model?

Answer 17

The price level moves up when AD increases and remains at the same level until there is a further increase in AD.

(PL cannot move down once moved up)

Question 18

What are automatic stabilisers?

Examples?

Answer 18

Automatic stabilisers are factors that automatically, without government intervention, work towards stabilising the economy.

Examples: Progressive income taxes, Unemployment benefits.

Question 19

Explain how progressive income taxes act as automatic stabilisers during both inflationary and deflationary parts of the business cycle?

Answer 19

Inflationary: as real GDP rises, so do incomes. Therefore, government tax revenues automatically increase, causing disposable (after-tax) income to be lower than it otherwise would be, creating downward pressure which dampens the boom.

Deflationary: as real GDP falls, so do incomes. Therefore, government tax revenues automatically decrease, causing disposable (after-tax) income to be higher than it otherwise would be, creating upward pressure which dampens the bust.

Question 20

How does the progressiveness of a tax system tie into the effectiveness of its function as an automatic stabiliser?

Answer 20

The more progressive a tax system is, the greater the stabilising effect on economic activity.

Question 21

Explain how unemployment benefits act as automatic stabilisers during both inflationary and deflationary parts of the business cycle?

Answer 21

Inflationary: as real GDP rises, unemployment falls, and so the number of people claiming benefits. Therefore, they receive less income than if they were employed and receiving benefits, creating downward pressure on a boom.

Deflationary: as real GDP falls, unemployment rises, and so do the number of people claiming benefits. As they have more disposable income than they would if they were unemployed and there would be no benefits, and able to consume and demand, creating upward pressure on a bust.

Question 22

How is the effectiveness of fiscal policy linked to the Keynesian multiplier?

Answer 22

The effectiveness of fiscal policy is affected by the size of the multiplier:

• the larger the multiplier, the stronger the impact of the policy on real GDP
• also, an increase in government spending has a larger impact on AD than a decrease in taxes.

Question 23

What is the Keynesian multiplier equation and what are the components?

Answer 23

MPC + MPS + MPT + MPM = 1

MPC = Marginal propensity to consume

MPC = Marginal propensity to save

MPT = Marginal propensity to tax

MPM = Marginal propensity to import

Question 24

How can you calculate the Keynesian multiplier?

Answer 24

Multiplier = 1 / (1 - MPC)

Question 25

What does a Keynesian multiplier of X mean?

Answer 25

That if the government increases spending by 1, it follows that AD will increase by X.

E.g. if X=4, that a spending increase of $2 would cause a shift in AD of $8

Question 26

What long-term effects can fiscal policy have on the economy?

Answer 26

• Indirect effects such as stability and ability to plan for long-run (consumers and producers know how much they pay in taxes, how much they might receive from the state etc.)
• Spending on physical capital: allocating spending to sectors such as R&D, infrastructure, technology etc.
• Spending on human capital: allocating spending to education, training, apprenticeships etc.
• Encouraging FDI: low corporate tax rates could encourage firms to set up in a country and to have their headquarters there e.g. Ireland.

Question 27

What are five strengths of introducing fiscal policy?

Answer 27

• Pulling an economy out of a deep recession: Keynesian economics, Roosevelt’s “new deal”
• Dealing with rapid and escalating inflation: contractionary fiscal policy could be used effectively.
• Ability to target certain sectors: target underperforming and deprived sectors/regions, e.g. HS2
• Direct impact on AD: government spending is a component
• Ability to affect potential output: long-term implications

Question 28

What are six weaknesses of fiscal policy?

Answer 28

• Problems with time lags: recognising a potential issue, passing legislation, the policy takes effect
• Political constraints: bias, corruption, to make the government ‘look good’
• Crowding out: the policy has a smaller effect than planned or no effect
• Inability to deal with supply-side problems: wouldn’t really correct cost-push inflation
• In a recession, tax cuts may not be effective: people may just want to save it instead so the money becomes static
• Inability to ‘fine-tune’ the economy: difficult to calculate and control the actual effect of the intervention

Question 29

What is monetary policy?

Answer 29

Monetary policy is carried out by central banks of each country which seeks to alter spending in the economy to meet macroeconomic objectives.

Question 30

What is the central bank?

Answer 30

A central is usually a government financial institution which produces currency and which implements monetary policy.

Question 31

What are the four responsibilities of a central bank?

Answer 31

• Banker to the government
• Banker to commercial banks
• Regulator of commercial banks
• Conduct monetary policy

Question 32

Why should a central bank be independent?

Answer 32

To allow for decisions free from political bias in order to achieve macroeconomic objectives more effectively.

Question 33

What is an interest rate?

Answer 33

The rate at which the cost of borrowing increases over time (usually given as a percentage)

Question 34

What is money?

Answer 34

Money is defined as anything that is acceptable as payment for goods and services, usually consisting of currency or cheques.

Question 35

What are the four functions of money?

Answer 35

1) Medium of exchange
2) Unit of account
3) Store of value
4) Standard of deferred payment

Question 36

What does an increase in the supply of money cause?

Answer 36

An increase in the money supply causes a fall in the rate of interest and vice versa.

Question 37

What does the demand and supply curve look like in the money market?

Answer 37

On an interest rate vs. quantity graph, the supply of money is at a set quantity and is vertical (perfectly inelastic), the demand of money is a demand curve that intercepts supply at the interest rate.

Question 38

What tools can the central bank use to implement monetary policy?

Answer 38

• Base rate
• Open market operations (OMOs)
• Quantitative easing
• Central bank reserve requirements
• Exchange rates (if fixed)

Question 39

What does expansionary policy intend to do?

Answer 39

To increase real GDP, create inflationary pressure, increase inflation.

Question 40

What does contractionary policy intend to do?

Answer 40

To decrease real GDP, create deflationary pressure, decrease inflation.

Question 41

What combination of fiscal policy and monetary policy might be implemented in a recession?

Answer 41

Expansionary policy

Question 42

What combination of fiscal policy and monetary policy might be implemented in a boom?

Answer 42

Contractionary policy

Question 43

What is inflation targetting?

Answer 43

IMF definition:

The public announcement of medium-term numerical targets for inflation with an institutional commitment by the monetary authority to achieve these targets.

Question 44

What are some advantages of inflation targetting?

Answer 44

• Lower rate of inflation
• More stable rate of inflation
• Improved ability of economic decision-makers to anticipate future inflation
• Greater coordination between monetary and fiscal policy
• Greater central bank transparency and accountability
• Rationalising expectations

Question 45

What are some disadvantages of inflation targeting?

Answer 45

• Unable to pursue other macroeconomic objectives
• Reduced ability of the central bank to respond to supply-side shocks
• Reduced ability to deal with unexpected events such as financial crises
• Finding an appropriate inflation target
• Difficulties with implementation

Question 46

What are five strengths of monetary policy?

Answer 46

• Relatively quick and cheap implementation
• Central bank independence
• No political constraints
• No crowding out
• Ability to adjust interest rates incrementally (small steps)

Question 47

What are five weaknesses of monetary policy?

Answer 47

• Time lags
• Possible ineffectiveness in recession
• Conflict between government objectives
• Inability to deal with stagflation
• Liquidity trap (effective lower bound)

Question 48

What is the effective lower bound and liquidity trap?

Answer 48

The effective lower bound is the demand for money is perfectly elastic, so any decreases in the base rate will have no effect on the demand of money as consumers and firms are unwilling to spend.

This causes a liquidity trap; to unlock liquidity, quantitative easing is needed to buy government bonds and inject more money into the economy

Question 49

What is the rate of return of a bond called?

What are the two types?

Answer 49

Yields

They can be calculated as either “flat”/”current” yields or as yield to maturity.

Question 50

How do you calculate a ‘flat’ yield?

Answer 50

( Coupon/market value ) x 100 = %

This is not that accurate.

Question 51

How do you calculate a yield to maturity?

Answer 51

[(coupon - capital losses per year) / market value] x 100 = %

Question 52

What are supply-side policies?

Answer 52

Policies that focus on the production and supply side of the economy, and specifically factors aimed at shifting LRAS to the right.

Question 53

What are the two types of supply-side policies?

Answer 53

• Interventionist
• Market-based

Question 54

Define:

• Interventionist policies
• Market-based policies

Answer 54

Interventionist policies: policies that rely on government intervention to achieve growth in potential output; Keynesian economics view.

Market-based policies: policies that emphasise the importance of well-functioning competitive markets in achieving growth in potential output; monetarist/neo-classical economics view.

Question 55

What are some interventionist supply-side policies?

(4)

Answer 55

• Investment into human capital
  
  • Direct provision of training and education (state schools and public training programs)
  • Improved health care services and access (free state healthcare e.g. NHS)
• Investment into new technologies
  
  • Research and development
  • Energy production methods (e.g. nuclear)
• Investment into infrastructure
  
  • Improvements and maintenance of public infrastructure (e.g. roads, ports, telecommunication)
• Industrial policies: policies designed to support the growth of the industrial sector
  
  • Support for small/medium-sized enterprises (SMEs)
  • Support for ‘infant industries’

Question 56

What are the three main categories for market-based policies?

Answer 56

1) Encouraging competition
2) Labour market reforms
3) Incentive-related policies

Question 57

What are some market-based supply-side policies that are directed at encouraging competition?

(6)

Answer 57

• Privatisation: the transfer of ownership of a firm from the public sector to the private sector.
• Deregulation: the elimination or reduction of government regulation of private sector activities.
• Private financing of public sector projects: allowing a private firm to do something (e.g. build an office block) which the government would later buy.
• Contracting out to the service sector (outsourcing): using contracted companies to provide a public sector service (e.g. building companies, UK train companies).
• Restricting monopoly power: increased competition resulting from anti-monopoly legislation.
• Trade liberalisation: negotiating free trade agreements with other countries

Question 58

What are some market-based supply-side policies that are directed at labour market flexibility?

(4)

Answer 58

• Abolising minimum wage
  
  • Highly controversial, but if the market equilibrium is above, could be beneficial
• Weakening the power of labour (trade) unions
  
  • Allows for greater responsiveness of wages to market forces
• Reducing unemployment benefits
  
  • To provide an incentive to work rather than live on the incentive
• Reducing job security
  
  • To allow firms to make it easier to let underperforming workers go, to boost efficiency

Question 59

What are some market-based supply-side policies that are directed at incentive-related policies?

(3)

Answer 59

• Lowering personal income taxes
  
  • Encourages aggregate demand as well as the incentive to work more
• Lowering taxes on capital gains and interest income
• Lowering business taxes

Question 60

What arguments for interventionist and market-based policies for the purposes of economic growth?

Answer 60

Interventionist: Increased spending on R&D, technology, education and training and favourable credit agreements (e.g. student loans) can increase LRAS. Additionally, industrial policies that benefit certain industries have proven to rapidly grow the economy e.g. Asian tigers.

Market-based: Intervention leads to inefficiency, misallocation and political bias resulting in wasted public spending and not achieving long-run growth. Additionally having high taxes to then use on stimulus can be seen as counter-intuitive.

Question 61

What arguments for interventionist and market-based policies for the purposes of employment?

Answer 61

Interventionist: education and training allows the workforce to acquire skills; provides assistance to reallocating workers (structural unemployment); the state is an employer

Market-based: may actually increase unemployment short term as firms try to be more efficient; contracting out to the private sector creates demand and employment; deregulation allows firms to select more and better labour as the labour market is more competitive

Question 62

What arguments for interventionist and market-based policies for inflationary pressure?

Answer 62

Both attempt to reduce inflationary pressure (SRAS shifting left)

Question 63

What arguments for interventionist and market-based policies for the government budget?

Answer 63

Interventionist policies rely heavily on the government to run them, so can take up a lot of the budget and can be unstable during political problems and changes to leadership.

Market-based policies rely less on the government budget but can also be unstable during political problems and changes to leadership.